A Tax Revolt in Japan, and a Bond Bubble Too

About 200 housewives marched down a shopping street in central Tokyo, beating pans with ladles and shouting slogans criticizing a government plan to double Japan’s 5 percent consumption tax. “Ordinary people like us have a limited amount of money we can spend each month,” says Natsuyo Makabe, a protester who took part in three demonstrations in June against the tax hike as well as nuclear energy and a free-trade pact. “Ninety-nine percent of the public will have to cut back on what they buy.”

The apron protesters, as they are known, argue that a tax increase would crimp household budgets just when the economy can’t withstand a drop in consumption. They say it’s a bad time for Prime Minister Yoshihiko Noda to rein in public debt that will be over 230 percent of national output this year, the biggest anywhere. The tax hike cleared the lower house of Japan’s Parliament in June. Noda got the tax approved by the upper house on August 10 by promising to hold early elections. That’s a dangerous bargain; his coalition has already started to crumble because of opposition to the tax.

Japan’s debt is ballooning as its population is aging and shrinking, meaning there are only 2.4 working-age Japanese to support one senior citizen now, compared with 9.1 in 1965. If he gets this tax hike wrong, Noda could throttle consumption, reduce tax revenue, and still leave Japan deep in debt.

Yet Japan’s bonds have never been more popular. The ticking fiscal time bomb—can Japan cut its budget deficit and sovereign debt before it’s too late?—is being drowned out by noise from the euro crisis, which has turned Japan into a haven for bond investors. Foreign ownership of Japanese government bonds rose to a record 8.3 percent last year. Yields on the 10-year benchmark recently fell to 0.72 percent, the lowest since 2003. Only Switzerland pays less to borrow. Yet Japan’s debt comes to about $93,000 per person, compared with about $33,000 in both the U.S. and Greece, according to Bloomberg data.

Japan’s current account surplus (a combination of a trade surplus and repatriated funds from abroad) means it’s not dependent on foreign investors to soak up its bond issues, according to Genji Tsukatani, portfolio manager at JPMorgan Asset Management Japan. He says Japan is at low risk of default. Takeshi Fujimaki, a former adviser to investor George Soros, disagrees, warning that the local bond market is a bubble that will pop in the next five years. “I wouldn’t be surprised if we see a default happening tomorrow,” he says.

J. Kyle Bass, founder of hedge fund Hayman Capital Management, has been betting on a collapse in Japan’s bond market since at least 2009. He predicts Japan will start experiencing regular trade deficits as the strong yen drives more Japanese manufacturers abroad. The trade deficits, along with declining savings, will trigger a rise in yields to the point where the cost of servicing Japan’s debt exceeds government revenue, he says. He acknowledges that other bond investors have nicknamed his short position the “widow-maker” since betting against the Japanese bond market to date has been fruitless.

Cracks are already appearing, however. A surge in energy imports to compensate for nuclear plants idled after last year’s quake gave Japan a record current account deficit in January. JPMorgan expects the shortfall to become chronic by 2015. Barclays (BCS) thinks the switch will happen in 2018. The Government Pension Investment Fund oversees 113.6 trillion yen ($1.45 trillion) and is historically one of the biggest buyers of Japanese debt, currently about 63 percent of its assets. Late in July it revealed that pension payouts already exceed revenue as baby boomers turn 65 and qualify for payments. “We need to sell Japanese government bonds to raise cash,” says the fund’s president, Takahiro Mitani. If too many institutions have to sell bonds, yields will rise.

Noda’s tax hike would lift the sales tax to 8 percent in 2014 and 10 percent in 2015. The increase would cost a family of four an extra 119,369 yen per year on average, according to the Daiichi Life Research Institute. “We’ll have no money to put into our saving accounts,” says protester Makabe.

The effect of families cutting back will be catastrophic for the economy, says Shinichi Kobuki, who organized the march attended by Makabe. “We’re still in the deflationary slump, our salaries are getting lower, and small businesses are going bankrupt,” he says. “The consequence of the bigger tax burden would be worse than just individual lives getting bitter.”